Review

Reviewed Work(s): Decision Analysis: Introductory Lectures on Choices Under

Uncertainty. by Howard Raiffa
Review by: Alvin K. Klevorick
Source: The Journal of Finance , Dec., 1969, Vol. 24, No. 5 (Dec., 1969), pp. 1000-1003
Published by: Wiley for the American Finance Association

Stable URL: https://www.jstor.org/stable/2325714

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms

and Wiley are collaborating with JSTOR to digitize, preserve and extend access to The Journal
of Finance

This content downloaded from

72.138.231.75 on Sun, 02 Jan 2022 05:05:16 UTC
All use subject to https://about.jstor.org/terms
 1000 The Journal of Finance

Decision Analysis: Introductory Lectures on Choices Under Uncertainty. By HowARD

RAIFFA. Reading, Massachusetts: Addison-Wesley, 1968. Pp. xxiv + 312. $4.95
(paper).
One of the people most closely associated with the development of Bayesian decision
theory and its application to business problems has been Howard Raiffa. It would
therefore seem valuable on a priori grounds alone to have him write an introduction
to the subject, stressing the foundations of Bayesian decision theory and articulating
the philosophical issues over which statisticians might respectfully disagree with one
another. In Decision Analysis: Introductory Lectures on Choices under Uncertainty
Raiffa has done precisely this. The finished product strongly confirms one's prior
judgment. With the prior distribution and the likelihood function both strongly peaked
at the point corresponding to the hypothesis that it is an excellent idea for Howard
Raiffa to write an introduction to Bayesian decision theory, this reviewer's posterior
distribution accordingly also reaches a very steep peak at this point. Decision Analysis
by Howard Raiffa is an excellent book.
Bayesian decision theory, which requires that a decision-maker's attitudes toward
outcomes be described by a numerical-valued utility function and that his judgments
about uncertainties be described by a numerical subjective probability distribution, is
presented in a systematic way as a viable procedure for making difficult and impor-
tant decisions under uncertainty. The author has made a conscious and successful
attempt to minimize the mathematical demands on the reader. Hence, while some
sophistication in logical analysis is required throughout the book, the reader who has
never had a calculus course will still be able to benefit greatly from a careful reading
of the volume. The more mathematically-trained reader will find the path through the
material much easier. He will especially appreciate the sections which develop side
issues that Raiffa finds interesting.' All but the mathematically trained reader who
has read extensively in decision theory will find material in Raiffa's book that is new
and interesting.
Raiffa considers the following basic decision situation. An individual must determine
a course of action, the net result of which depends on the uncertain state of the world.
The decision-maker has some information about the uncertain world he faces and can
make some judgments about these uncertainties. Finally, by sampling or experimenta-
tion the decision-maker can obtain further information about these uncertainties. The
question then posed is how can such an individual perform an analysis that will lead
him to his "best" course of experimentation and action, where "best" means the
course logically consistent with his basic preferences for outcomes and his basic
judgments about the unknown state of the world.
In the first two chapters Raiffa presents a concrete example of this abstract struc-
ture with the reader cast in the role of the decision-maker, as well as a few sketches
of decision problems which fit this mold. This example provides the basis for an
excellent exposition, in Chapters 2-7, of the Bayesian theory of decision-making under
uncertainty. Beginning with the simple case in which all probabilities are objectively
known and the decision-maker is risk-neutral (so that his goal is maximization of ex-
pected monetary value), the reader is next led to consider the possibility that sampling
costs are stochastic, that the ultimate outcome for any given state of nature is stochas-
tic, and finally that there may exist measurement error in experimentation. Retaining

1. Raiffa has carefully indicated these sections with signposts of warning to the reader who is
experiencing greater difficulty with the material. It should be noted that Raiffa's signposts are,
indeed, very good. Those sections which are marked with an asterisk can be omitted without loss
of continuity.

This content downloaded from

72.138.231.75 on Sun, 02 Jan 2022 05:05:16 UTC
All use subject to https://about.jstor.org/terms
 Book Rewews 1001

the assumption that all probability distributions are known objectively, Raiffa then
introduces the possibility of non-neutral attitudes toward risk, in particular, the pos-
sibility that the decision-maker is risk-averse. This provides the background for de-
velopment of the modern theory of utility based on the work of Von Neumann and
Morgenstern. Turning to the case where the probability distributions are not objec-
tively known, the procedure for translating hunches or vague impressions into judg-
mental probabilities is presented together with the case in favor of performing this
translation. In this discussion of the modern theory of subjective probability, based
on the work of L. J. Savage and others, Raiffa aims to persuade the reader that the
resulting judgmental probabilities ought to be treated as if they were "hard" objective
probabilities. Having completed his discussion of the extensive form of Bayesian
decision analysis, Raiffa then introduces the reader to the normal form of analysis in
which the decision-maker's evaluations are in terms of complete strategies for experi-
mentation and for action. He concludes his exposition of the basics of Bayesian theory
with an introduction to Bayesian sampling theory.
The exposition of the Bayesian position presented in Chapters 2-7 is excellent. One
especially good feature of Raiffa's presentation in these chapters is that he brings the
novice into contact with some of the more-advanced concepts and frontier issues in
the field of decision theory. For example, the concept of decreasing risk aversion,
which is of quite recent origin, makes its way into the text as does a very brief picture
of the idea of stable estimation, even though the latter is not identified as such.
Raiffa also presents one of the better discussions I have seen of the Allais paradox
in expected-utility theory, an interesting discussion of the buying and selling prices
of a lottery for an individual, and an interesting observation on the appropriate utility-
of-wealth curve for a risk-loving decision-maker who lives in a world where fair
gambles exist.
There is but one shortcoming in the exposition of the basic theory, and it is notice-
able only because of the high quality of Raiffa's exposition throughout the text.
Specifically, it would have been desirable to have, at least in an appendix, an explicit
statement of the axiom systems underlying the concept of Von Neumann-Morgenstern
utility and subjective probability. For example, a shorter version of Luce and Raiffa's
(Games and Decisions, John Wiley and Sons, Inc., 1957) discussion of the axiomatic
approach to utility theory with a parallel treatment of subjective probability would
have been a welcome addition to Raiffa's current book. The axioms concerning tran-
sitivity of preferences and substitutability of indifferent consequences in a lottery are
emphasized by Raiffa while the other postulates, for example, the continuity, algebra-
of-compounding, and monotonicity axioms, are referred to simply as assumptions or
observations. The complete axiom system is never stated as an entity. Given his ex-
positional skill, I think beginners would have benefited greatly if Raiffa had discussed
the logical structure of the axioms.
The remaining three chapters of the book discuss theoretical extensions of the basic
theory, implementations of the procedures, and broader perspectives for viewing the
basic discussion of the first seven chapters. Chapter 8 makes the group, rather than the
individual, the basic decision-making unit as it considers the question of risk-sharing
and other topics in group decision-making under risk. Raiffa writes in his Preface
that he wrestled with the thought of deleting this chapter. We should all be glad he
did not do so. The chapter raises some fascinating questions, questions whiclh obviously
remain open to further discussion and research.
In the discussion of risk-sharing, Raiffa first shows that there may be lotteries that
are not acceptable to any one member of a group but which admit some mutually
acceptable partition as lotteries among the group members. The bargaining-problem

This content downloaded from

72.138.231.75 on Sun, 02 Jan 2022 05:05:16 UTC
All use subject to https://about.jstor.org/terms
 1002 The Journal of Finance

and syndicate-problem approaches to a choice among Pareto-optimal partitions are

then discussed briefly, after which Raiffa goes on to consider how a group might
choose among lotteries when risk-sharing is permissible. He obtains some strong results
for the special case where each decision-maker has an exponential (constant-absolute-
risk-aversion) utility function:

u1(xi) 1 exp {-xVci}.i

In the more-general case, however, the only result obtained is the negative one that
when risk-sharing exists, it is not always possible to construct some group utility func-
tion that depends only on the individual utility functions and that appropriately
guides external behavior.
In the second part of Chapter 8 Raiffa considers how differences in subjective prob-
ability assessments and in preferences for outcomes that jointly affect a group ought to
be resolved by the members of that group. Suppose the group members agree on the
utility values of the outcomes and on the conditional probability assessments for ex-
perimental results given a state of nature but disagree on their assessments of the
underlying states. In this instance, Raiffa presents a persuasive case for the group's
compromising on a prior distribution over the states of nature before taking a sample,
and then using the sample results to revise their group prior distribution. Assume, in
contrast to the situation just described, that the group members do not agree on the
utility values of the outcomes. Should the group then follow the same approach sug-
gested to individuals and decompose its problem, processing its preferences for out-
comes separately and independently of its judgments about uncertain events? If the
principle of substitutability conflicts with that of Pareto optimality, which dictum
should be followed? These questions have no definitive answer and the issues involved
essentially divide the Group Bayesians from the Paretians. The former argue that
the individual-rationality assumptions are equally forceful when the group is the
decision-making unit. The Paretians, on the other hand, argue that Pareto optimality
is inviolable.
Raiffa's view-with which this reviewer would concur-is that when the group in
question is acting in an advisory capacity to an individual who must make the ultimate
decision (Raiffa's "Problem of the Panel of Experts"), then the evaluations ought to
be made at the fundamental level following the Group Bayesian position-use the
opinions of the experts to assess a single utility structure and a single probability
structure, keeping the assessments of utilities separate from the assessment of proba-
bilities. As Raiffa shows, this can imply the sacrifice of Pareto optimality because the
decision-maker may be led to choose an action which each expert would say is not as
good as an available alternative. On the other hand, when the group involved is the
final decision-making unit, Raiffa presents an example in which the Group Bayesian
position seems much less convincing than the Paretian view. This example involves
what one might call "internal logrolling" among members of the group, a phenomenon
which is highly unlikely only in the most cohesive groups of idealistic responsible in-
dividuals.
The issues raised by Raiffa in this excellent chapter on risk-sharing and group deci-
sions in the face of uncertainty are not only of academic interest, but also have con-
siderable practical importance for decisions that must be taken in real-world settings.
For example, what are the implications of this discussion for the goal of a firm
budgeting its capital in an environment of risk and imperfect capital markets? What
is the relevant objective function and how does it take shape? Is there a higher entity
in the form of The Corporation whose utility function is the relevant one or is it
better to evaluate investment projects as a bargaining problem among different indi-

This content downloaded from

72.138.231.75 on Sun, 02 Jan 2022 05:05:16 UTC
All use subject to https://about.jstor.org/terms
 Book Reviews 1003

viduals who happen to be united under the umbrella of a particular corporate struc-
ture? If there is a corporate utility function, who is assigned the task of "perceiving"
it-the managers, the board of directors?
Chapter 9 discusses how one might go about implementing the Bayesian decision
theory set out earlier and presents a "cost-benefit" analysis of decision analysis.
There is one part of this chapter about which I feel uncomfortable. I believe Raiffa
has given a somewhat-misleading answer to the very difficult and important multi-
attribute problem. The question at issue is how does one assign utility values to con-
sequences that can only be specified by a vector of attributes rather than by a single
attribute?
Raiffa's suggestion is completely correct for the case where the trade-off rates among
attributes are constant, but where these indifference surfaces are nonlinear, I believe
his suggestion is not operational. He suggests that we proceed as follows if we wish
to arrive at a single utility number to describe a consequence with a pair of attributes,
say (x,y). First, set y at some value y*; then, for each (xi,yi) pair find the value of
xi, call it x*, such that (x*,y*) is indifferent to (xi,yi); and finally, "keeping the
value of y* in mind," scale the pairs of consequences attributes by associating utility
numbers with each of the x* values.
I am afraid I do not understand what this means operationally. The difficulty is
that while Raiffa's procedure will yield an appropriate ordinal preference ranking, it
cannot really be used for expected-utility maximization unless the procedure for
"keeping the value of y* in mind" is explicitly set forth. If utility values are attached
to the scalar quantities xt alone, the value assigned to an (xi,y1) pair will depend on
the value, y*, at which y is fixed. Unless we know how to adjust operationally for
changes in y* (which information Raiffa may subsume in "having an indifference
map"), different y* valu.es may lead to different decisions being taken to maximize
expected utility. I may, however, simply be misunderstanding the author's discussion
of this point.
Raiffa's excellent introduction to Bayesian decision theory is all the more useful
because of its final chapter which places Bayesian decision theory in a broader
perspective, viewing it in relation to the different schools of statistical thought, game
theory, gaming, operations research, and systems analysis. The brief sections pre-
senting historical perspectives of subjective probability and an overview of statistics
are truly first-rate.
The book should be very valuable as supplementary reading or as the main text
for part of the term in courses in statistics, mathematical economics, or case studies
in business decisions.
In the opening chapter, Raiffa writes, "I belong to a minority party, the so-called
Bayesians, . . . and in the course of these lectures I shall set forth my party platform
as I see it" (p. xx). Decision Analysis can only help to strengthen this minority party
and to highlight the differences between it and the majority party.
ALVIN K. KLEVORICK
Yale University

Guide to Convertible Securities. By WILLIAM SCHWARTZ and JULIUS SPELLMAN. New

York: Convertible Securities Press, 1968. Pp. 100. $10.00.

This is essentially a pragmatic text, designed to serve the needs of investors as well
as issuers of equity-privilege securities. The Guide deals exclusively with convertible
securities and warrants and with the strategies of arbitrage, hedging, and option-writing

This content downloaded from

72.138.231.75 on Sun, 02 Jan 2022 05:05:16 UTC
All use subject to https://about.jstor.org/terms